Drill Down: What is a mutual fund?

A mutual fund pools the money from many different investors. A professional investment manager picks the stocks or bond in which the fund invests. It’s good for investors because it is well diversified. It is cost effective because the fund’s expenses are spread among many different investors.

Mutual funds come in a wide variety of flavors, though, so the investor must decide how much to invest in stocks, how much in bonds, and how much in other choices. The specific choices vary from company to company, but almost every company offers a good selection to choose from.

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Drill Down: More about what's great about a 401k

There are some nice advantages to using a 401k for one of your investment boxes. First, some employers match your contributions. For example, a company may match half of what you put in. They usually add an upper limit on how much they match, such as six percent. So if you put in six percent of your pay, they would add another three percent, for a total monthly savings of nine percent of your pay. Let’s say you make $40,000 per year. Six percent is $2,400 per year. The company would throw in another $1,200. That is, the company will give you a raise just for contributing. Another way to look at the company match is that you’ve just made a 50 percent gain on your investments. Even the great stock market investors would be delighted to have a guaranteed instant 50 percent return. Another common match is dollar for dollar on the first three percent of your pay that you contribute. That gives you a 100 percent return on your money. It’s a fantastic deal. Just remember, though, that under this formula if you contribute more than three percent, the company does not match the extra amount. While not all companies match employee contributions, there are more good reasons to enjoy your 401k.

Another good reason includes the tax deferral and compound interest that vastly increase your 401k’s growth rate. For instance, with a regular 401k, your contribution goes in before taxes are collected. In the example of the $40,000 worker who contributes $2,400 a year to his 401k, the government pretends that this person is only earning $37,600. They don’t completely ignore the 401k contribution, but they allow it to grow tax deferred, not taxing it in the year that you earn the money and contribute to the 401k. After you retire and withdraw some of the money in your 401k, the IRS will say that it’s time for you to pay some tax. Even after paying the tax, you will be ahead of the game because your earnings compounded every year without a tax bite. Later on, I’ll show you some numbers about how much better off you are when you let your money compound without taxes. For right now, trust me on it.

You may have a choice about whether to set up a regular 401k or a Roth 401k. They have very similar advantages, but one key difference. With a Roth 401k, you have to pay taxes on the money that goes into the 401k, but you pay no taxes at all when the money comes out during your retirement. Compound growth is the key to the whole thing. You may be more familiar with the term “compound interest.” Compound growth is the same idea, but recognizes that some of your gains are from dividends and increasing prices of stocks, not interest. A third reason is that your savings is automatic in a 401k. Most humans have a tough time putting money away for their retirement. I’ve heard that beings from the planet Zorg always set aside money for the future before spending money on today’s needs and wants. Unless you are from that planet, you probably have a hard time saving. The 401k is great for you. The money goes directly from your company into your account, without ever tempting you to spend it. Do you want to be a millionaire, while earning only an average salary? Not a problem if you contribute to your 401k and your employer offers a match of, let’s say, three percent on top of your contribution of six percent. Let’s say that you are smart enough to read this when you’re only 22 years old, and you plan to retire at age 62. You don’t want to take extreme risk, but you can accept moderate fluctuations in your investments. If your income is right at the middle of the income distribution ($46,000 as of the time I’m writing this), you’ll make it with your 401k! (Oops, I can’t actually guarantee that. You’ll learn more about investment returns later on, but I can say that the most likely case is that at age 62 your 401k will have $1,080,095 in it.)

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Drill Down: The decisions you'll have to make

You do have to make some decisions, however, and that scares away a lot of people. But don’t worry, I’ll make the decisions easy for you. Your first key decision is whether to set up a 401k account at all, and if so, whether it should be a regular 401k or a Roth 401k. Then you must decide how much to invest. You have current needs, and you also have investment alternatives such as an IRA, a college savings account, and cash stuffed into a mattress. Later on, I’ll help you figure out how much to contribute.

You will have to make some investment decisions. When you leave your current employer to go to work for someone else, you’ll have to decide what to do with your old 401k. The choice is simple, but you have to make sure that you do it right to avoid excess taxes. I’ll explain that later.

You may consider taking out a loan from your 401k plan, or making a hardship withdrawal. I will help you understand when you should take either of those actions. Death and divorce are two sad topics that should be considered when you set up your 401k. The law is often not what you expect regarding 401k plans, so pay attention here.

When you retire, you’ll have some decisions to make about withdrawing your money. This is the fun time: spending! Again, I’ll explain the decisions you have to make for your 401k withdrawal, and which ones work best. Again, all these decisions scare some people, but I’m going to make it easy for you. I’m going to walk you through all of the steps, holding your hand. I’ll help you figure out how much to contribute, what to do with your old 401k, and how to make the best withdrawal decisions. Relax. It will be a great start toward financial security.

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Drill Down: Your 401k and the rest of your life

You have a life apart from your 401k. That’s as it should be. Your 401k is not jealous. For best results, you should integrate your 401k decisions with the rest of your life. The major points of decision regard contributions to your 401k plan, how to invest those contributions properly, and how to withdraw funds in retirement.

Should you contribute to your 401k before a college savings plan for your children? Before an IRA or Roth IRA? Before saving for a house, or paying off the credit card bills? It’s easy for us writers to say fully fund your 401k—we’re not worrying about your children, your house or your IRA. But there are some good rules that can help you make wise decisions about which debt to pay off before you begin 401k contributions. There’s also a good strategy in the next chapter where I’ll lay out how you should prioritize 401k contributions and other uses for your money.

Investment decisions should be integrated across all of your investment vehicles. Most young families have a 401k as their only investment, so decision making is easy. However, middle aged folks with other investments—such as IRAs, stock or mutual fund holdings, and investment real estate—will want to think about how their 401k interrelates with other investments. This adds some complexity, but that’s a small price to pay for having more assets. The general rule I’ll advance later is this: First, choose what investments you want to own, and then decide in which accounts the various investments should be made. In this approach, the 401k is nothing special, just another investment box.

When you have retired, you’ll need some money. You will have to choose from where you will take the money you need: your 401k or IRA, the sale of stocks or real estate, or cash in your bank certificate of deposit. This is fairly easy to figure out, but doing it right will save you a ton of money in taxes.

Think of your 401k as just another tool. It’s a great tool, versatile and inexpensive, but no one tool can do everything. To achieve financial security, you need to use this tool in conjunction with others, and use it wisely.

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